How Capitalism Will Save Us

by Steve Forbes

  What would the poverty rate be if the Census Bureau used a Real World methodology? According to Besharov, the percentage of Americans living in poverty is probably a fraction of the government’s estimate—around 5.4 percent.

  Even Democrats on the congressional Joint Economic Committee agree that there has been “much greater progress in poverty reduction over the last two decades than the official poverty measure would indicate.”15

  Some go beyond Besharov’s critique to question the government’s fundamental definition of poverty. Nicholas Eberstadt of the American Enterprise Institute says the problem with the oft-cited poverty numbers is—as the critics noted above have suggested—they confuse “income” with standard of living.

  He explains, “For lower-income people especially, income tends to be an unreliable predictor of true living standards.” Many people who are today labeled as “poor” by the U.S. government actually have a higher living standard than those above the poverty line in the 1960s and ’70s. “In 1999, nearly 36 percent of all ‘poverty level’ African American households had central air conditioning—well over twice the figure for America’s white nonpoverty population in 1970.”16

  The government has also branded as “poor” levels of material wealth that would be considered affluent elsewhere in the world. For instance, according to the Census Bureau, over three-quarters of a million “poor” persons own homes worth over $150,000; and nearly 200,000 “poor” persons own homes worth over $300,000.17 These numbers do not reflect the hundreds of thousands of people who became homeowners during the subprime binge of 2004–2006. Even with substantial defaults of these particular mortgages, the fact remains that hundreds of thousands of supposedly poverty-stricken people owned valuable homes.

  A study in the 1990s found that an American considered “poor” in the eyes of the Census Bureau has one-third more living space than the average Japanese citizen and four times as much living space as the average Russian.18 Eberstadt believes “the poverty rate misleads the public and our representatives, and it thereby degrades the quality of our social policies. It should be discarded for the broken tool that it is—and a poverty rate worthy of the name should be crafted anew in its place.”19

  Another seldom-appreciated fact is that the gap between rich and poor often grows, at least temporarily, when an economy is expanding. Economist Brian Wesbury offers an enlightening explanation of why this happens:

  [I]ncomes at the top (earned by entrepreneurial innovators or early-technology-adopters) rise more rapidly. This divergence happens whenever growth picks up due to technological innovation. And it is even more pronounced in recent decades because of technology.

  For example, Michael Jordan and Tiger Woods earn much more than Larry Bird or Jack Nicklaus ever did because of the global reach of television. A rising income gap signals growth and opportunity for investors and the economy, and should not be viewed as a problem in a free economy. Income gaps in third-world countries, ruled by dictators, are a more serious development because they reflect exploitation and an abuse of political advantage.20

  As we’ve noted, equal incomes do not necessarily signify a healthy economy—and often they mean just the opposite. There was little inequality in the old Soviet Union, or, for that matter, economically impoverished communist Cuba. There was a lot less income inequality in the United States during the Great Depression—and there’s probably less now, during the current recession. There’s little income inequality when almost everyone is poor.

  REAL WORLD LESSON

  Statistics measuring poverty and “income inequality” are snapshots in time and essentially meaningless as measures of fairness or mobility.

  Q IF THE RICH ARE NOT GETTING RICHER AT THE EXPENSE OF OTHERS, WHAT ABOUT CEOS WHO GET MASSIVE PAY PACKAGES MANY TIMES THEIR WORKERS’ SALARIES—EVEN WHEN THEY’RE NOT DOING A GOOD JOB?

  A CEO PAY REFLECTS THE SCARCITY OF THE HIGHEST LEVEL OF MANAGEMENT TALENT. CEOS CAN DELIVER ENORMOUS BENEFIT TO THEIR COMPANIES. YET DESPITE THE LARGE NUMBERS, THEY COST WORKERS AND SHAREHOLDERS RELATIVELY LITTLE.

  The decades-old controversy over CEO pay reached a new level of intensity during the financial crisis. Jaws dropped in 2008 when CEO John Thain suggested that he should still get his $10 million bonus from Merrill Lynch, even as the struggling, money-losing company was about to be taken over by Bank of America. Thain was hardly the only executive whose pay incited outrage. Some $18 billion in bonuses was paid by Wall Street firms that had been bailed out with taxpayer money. President Obama called the situation “shameful” and imposed a $500,000 cap on the pay of top executives of banks that received federal TARP funds.

  As some later pointed out, not all the executives who received bonuses were highly paid CEOs, and Wall Street firms were contractually obligated to pay them. Nonetheless, the firestorm over bailout bonuses served to focus public attention on the broader issue of executive pay. Congress and the Obama administration have been mulling ways to restrict CEO pay at all public companies, not only those that are recipients of government largesse.

  Even in good times, it can be hard for people to comprehend the immense compensation paid to CEOs—including those as successful as Larry Ellison of Oracle. Number one on the Forbes 2008 list of top-paid executives, Ellison received a six-year average annual pay of $71 million, and he received a total of $192 million in 2007.

  Oracle, the software company that he founded, in addition to creating enormous wealth for stockholders, employs some 86,000 people. Although Oracle’s stock price has declined with the market, investors nonetheless have done well in the long term. If you had invested $100 in Oracle in 1990, it would be worth $4,000 today, despite the volatile ups and downs of the market.

  Ellison created immense wealth for shareholders before the stock market meltdown. Shareholders considered Ellison a sufficiently good deal in 2008 to vote against a “say on pay” provision that would have enabled them to curtail his compensation. They decided that Ellison’s package—high though it may appear—was not an overly steep price for leadership that has produced a financially healthy company generating more dollars for salaries and jobs.

  Another way to look at Ellison’s pay is to boil it down to the cost of each share of stock. Ellison’s $71 million average annual pay amounts to a cost of less than two cents per share.

  CEO compensation should be viewed in terms of the billions of dollars top executives help their companies generate. Executive-compensation consulting firm Watson Wyatt calculates that the top-five executives at U.S. companies receive only about 2 percent to 3 percent of the value they create for shareholders.

  Of course, not every CEO is a Larry Ellison. Few would dispute that Countrywide Financial CEO Angelo Mozilo was a miserable deal for employees and shareholders. The lender’s concentration in risky subprime mortgages was a disastrous strategic decision that led to the ultimate implosion of the company and its distress sale to Bank of America. At the bottom of the Forbes list of worst-performing CEOs, Mozilo ran his company into the ground while being paid around $66 million a year.

  What about Robert Nardelli? Before becoming head of troubled Chrysler, he received an astounding $210 million golden parachute after being fired from Home Depot, setting off a firestorm of public outcry.

  What’s going on here? Isn’t the stratospheric compensation of some CEOs the perfect example of “the rich getting richer” at other people’s expense—in this case, the bosses making a fortune at the expense of the workers and shareholders of their companies?

  The real question should be “Why do these pay packages persist in spite of decades of criticism?” The reason is that despite emotional claims to the contrary, they make sense in Real World economic terms. The benefits that good CEOs can deliver are enormous and far exceed the dollar value of their compensation.

  Unfortunately, CEO pay packages are negotiated before an executive takes a job and his or her performance is known. High pay can be necessary to get a talented executive to g
ive up an existing position with enormous pay and benefits. To get a top-tier CEO to take on a risky assignment, you have to pay what he or she is commanding on the open market. That was the case with Robert Nardelli. Home Depot had to entice him to come over from GE, where he had been one of three finalists to succeed the legendary Jack Welch. Almost all of his $210 million severance package was what Nardelli would have received had he stayed at GE. Controversial Ford CEO Alan Mulally—who received $28 million in his first four months on the job—had to be persuaded to give up a highly lucrative job and successful career at Boeing.

  Actually, most CEOs who get fired don’t get massive payouts. Megamillion-dollar golden parachutes are exceptional, which is why they make news. The average CEO makes about $14 million per year in total compensation—i.e., salary and the gains from the sale of stock options.21Still, for most people, this is enormous. But so is the CEO’s job. A top executive of a public company can preside over a corporation the size of an American city. As we mentioned, Oracle has 86,000 employees. That’s nothing compared to Procter & Gamble, which has 138,000. These massive corporate communities—for that’s what they are—encompass divisions and thousands of people in countries around the globe. Guiding them requires a singular combination of skills. A good CEO needs to know far more than how to make and sell a company’s products. He or she needs to understand finance and where global markets are going. Chief executives must also communicate with countless constituencies—workers, unions, customers, and suppliers, as well as regulators and media that are constantly scrutinizing their activities. It’s more than a twenty-four-hour-a-day job.

  Just as there are few people who have the skills and talent of a top baseball player like Alex Rodriguez or a singer like Rihanna, there are probably even fewer people who can run companies like IBM or P&G and do so successfully. Ford CEO Mulally, for example, aggressively downsized Ford—selling Jaguar for $2.3 billion while competitor GM was dithering about what to do with Saab and Hummer. Mulally also aggressively raised cash, both to develop new products and to give the company a financial cushion. As a result, Ford has not taken a government bailout, while GM and Chrysler were forced into government-orchestrated bankruptcies costing taxpayers tens of billions of dollars. GM has defaulted on its debts, while Ford is still making payments at this writing in the spring of 2009. While it’s unclear what the future holds, few would question that the millions paid to Mulally were a good investment not only for Ford but for the American taxpayer.

  Contrary to what activists allege, CEO pay is usually not the result of executives cutting sweetheart deals with crony boards of directors. Boards today are more independent than they once were. Shareholders can—and sometimes do—hold the line on pay considered excessive.

  Proof that market forces are what’s driving executive pay is provided by the fact that even higher CEO salaries are paid by private equity funds like TPG, Kohlberg Kravis & Roberts, and the Blackstone Group, firms run by veterans of corporate suites and sharp-eyed MBAs who have to answer to sophisticated clients obsessed with investment returns. American-style CEO salaries and bonuses are increasingly being paid in Europe, including in socialist France, where top executive compensation at the biggest companies increased 58 percent in 2007.

  Another reason CEO salaries have gotten bigger is because American corporations have gotten larger. According to a report from the National Bureau of Economic Research, “the sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the sixfold increase in market capitalization of large U.S. companies during that period.” Why this increase? One reason is the boom in stock ownership that has taken place over the past three decades. Sixteen million American households owned stock in 1983; 57 million do so today. Thus, today’s CEOs are responsible not only for managing bigger corporate entities, but for creating more value for more investors.

  Should there be caps on CEO pay? As we have said, executives command high pay because of their value in the marketplace. Corporations will therefore seek to pay desirable executives what they are worth, regardless of the efforts of bureaucrats. For this reason, past attempts by government to override the market and impose unnatural constraints on executive pay haven’t worked and have only made things worse. In 1993, President Clinton signed legislation designed to discourage high CEO pay by allowing deductions of no more than $1 million in CEO salary on corporate tax returns. What happened? Companies started paying executives with bonuses and stock options that can balloon in value. CEO pay packages grew even bigger.

  A more fruitful way to exert pressure on executive pay would be to remove certain barriers to shareholder challenges to management. Hundreds of publicly held companies protect themselves against hostile takeovers with “poison pill” measures—such as making it harder to get board control by limiting the number of directors who can come up for election each year. If companies could not resort to such poison-pill measures, managers would be less able to insulate themselves from shareholders seeking to install new management. They might be more sensitive to the appearance of their pay packages.

  This approach is distinct from “say on pay” measures, which give shareholders approval rights on individual executive compensation packages. Shareholders can’t micromanage companies. Businesses must have flexibility to operate day to day. If they don’t perform over time, shareholders should be able to make changes.

  There’s no question that some CEOs are overpaid. But the bottom line is that CEO compensation, astonishing as it may be to some, reflects market forces—high demand for top-level talent that’s in extremely short supply.

  REAL WORLD LESSON

  CEO pay reflects the value placed by the market on the handful of individuals equipped to lead global corporations.

  Q HEDGE-FUND TRADER JOHN PAULSON STUNNED EVEN WALL STREET BY EARNING $3.7 BILLION, ESSENTIALLY BY BETTING THAT THE HOUSING MARKET WOULD FAIL. DOES HE REALLY DESERVE THAT KIND OF MONEY?

  A PAULSON PROFITED FROM SHREWD ANALYSES THAT ENABLED HIM TO FORESEE THE COMING CRASH OF THE MORTGAGE MARKET. HIS HUGE PAYDAY REFLECTED THE ENORMITY OF THE DOLLARS HE WAS INVESTING, THE SINGULAR BRILLIANCE OF HIS TRADING MOVES, AND THEIR EXTREMELY HIGH RISK.

  When stories about Paulson came out in late 2007, even freemarket believers wondered: How could anyone legitimately make $3.7 billion in one year? Could this be a spectacular case of, to use a favorite term of left-leaning economists, “market failure”—a socially destructive fluke that should not have happened and that really should be prevented?

  Our reply: not only does Paulson “deserve” his $3.7 billion; his profit makes sense in Real World economic terms.

  Paulson operates in the complex, high-risk world of hedge funds, a far cry from your traditional mutual fund. Hedge-fund managers employ mind-boggling arrays of strategies, using puts, calls, options, and short sales. They deal in everything, including, of course, stocks, bonds, commodities, and currencies. What makes hedge funds high-octane vehicles is their use of borrowing on a scale that can take your breath away—a process that can magnify gains and losses.

  Paulson earned his historic reward because his hedge fund invested with exceptional success for the multibillion-dollar pension funds that are his clients. His investments in 2007 yielded an astounding $15 billion gain—a 600 percent return. His subsequent trades generated more than 17 percent gains for his clients despite a down market in 2008.

  The news media has characterized his trades as a “bet,” as though Paulson was playing the slot machines in Vegas. But his investment decisions were based on anything but luck. Paulson’s analysis led him to conclude that the housing market—fueled by so many low-interest, ill-advised subprime loans—was dangerously overheated. As he told journalist Gary Weiss, “We felt that housing was in a bubble; housing prices had appreciated too much and were likely to come down.”22 Mortgage-backed securities created by investment firms from bundles of mortgage loans were, as a consequence, drastically overvalued. His trades were predicated on the
belief that the market would eventually tumble, and that banks like Lehman Brothers, Washington Mutual, and Wachovia would find themselves in major trouble.23

  Paulson’s two-year “megatrade”—as it has been described—involved an assortment of tactics and financial instruments. One strategy was to sell short, risky, mortgage-backed securities called collateralized debt obligations, or CDOs, betting their value would soon decline. Another tactic was to buy credit-default swaps, which are a form of insurance against the failure of mortgage-backed securities if their underlying mortgages go bad. Paulson steadily bought credit-default swaps before the housing bubble showed any sign of bursting—when the instruments were cheap.

  He took on a staggering amount of risk. According to one account, he invested some $22 million in credit-default swaps alone long before the financial crisis hit.

  As all of us know by now, he was right big-time: homeowners began defaulting on their loans, and the value of Paulson’s credit-default swaps soared. When the federal government declined to rescue Lehman Brothers24 his $22 million investment in credit-default swaps paid $1 billion.

  Paulson made a fortune for himself and his clients precisely because he went against the then-prevailing wisdom. The very fact that most others lost in the market attests to the fact that he served his clients better than other money managers did.

  Paulson was hardly the only trader to see the downside of the subprime market. But unlike others, he surmised correctly that banks were not fully aware of its potential perils. Weiss writes:

  Other traders refused to short the big banks because they couldn’t believe that such huge institutions would be so unaware of their own risks. Once that fact dawned on Paulson, he bet, fast and big, that the banks would fail.25

  While appreciating this foresight, Weiss questions “the moral dimension of Paulson’s achievement.” He asks, “If he saw all of this coming, was it right for him to keep his own counsel, quietly trading while the financial system melted down? Do traders who figure out a way to profit from our misery deserve our contempt or our admiration, however grudging?” What Weiss and others should remember is that many bright people thought Paulson was wrong. Several economists, including New York University’s Nouriel Roubini, warned of the impending housing disaster and were routinely ignored.